Last year’s key call was to spot the indebtedness of peripheral European governments and go underweight quickly. Those who did prospered all year, but in January of this year they got a nasty shock as peripheral spreads came rattling in and peripheral financials bounced. The newsflow in January wasn’t especially conducive: on 6th, Santander struggled to get away a five-year covered bond, causing its CDS to spike 50 basis points; on 14th, European Central Bank (ECB) council member Axel Weber spoke about inflation threats and the possibility of tightening policy, and on 19th, the European finance ministers met and decided that they didn’t need to do anything.

To understand what is changing we need to look more deeply at the way in which Europe works. There is no unified government, and rather than speaking with a single voice the European Union tends to be a chorus of voices, not necessarily all in tune – indeed, there are two heads of Europe: Manuel Barroso, the head of the Commission, and Herman van Rompuy, the head of the Council, and it’s not clear that Chancellor Merkel or President Sarkozy see any need to defer to either of them. To get things done takes a lot of behind-the-scenes diplomacy, and a lot of give and take, which is why the visible sign that negotiations are taking place is a statement to the press about some new agreement by one of the participants which is then denied by the other participants. The overriding imperative, though, is the continued drive towards ever closer union, and unpopular measures such as the Irish bailout are presented as mandated by Europe.

Chart of spreads of peripheral eurozone bond markets over Germany[1]

With this background, what is happening now? In a recent themes note I mentioned the need for European leaders to understand that rhetoric alone will not convince markets of the sustainability of the eurozone – they need to take decisive action to design mechanisms that are properly funded, flexible, sensible, and not simply focused on ‘punishing’ markets. There have been a number of pieces in the papers in recent weeks indicating that negotiations are taking place over just such a package, but its scope may be wider than we had anticipated. The talk is of beefing up the European Financial Stability Facility (EFSF) and making it more flexible. What is also being hinted at is a series of accompanying measures that will attempt to remedy the shortcomings of the Stability and Growth Pact and make such debt crises less likely in the future. These measures may well include measures to abolish wage indexation agreements, to raise pension ages, to look at adjustments to corporate tax rates (watch out, Ireland), to improve banking supervision, and to adjust constitutions to prohibit excessive public debts. If we are right in thinking that these are now all under discussion, the beauty of tying them to the bailout package is that the central eurozone governments, led by France and Germany, now have enough leverage to bring the indebted periphery into line; not only that, but the measures to prevent a future crisis can be presented to German electors as giving them something back in return for their financial support. In Germany, after all, one of the themes in the press at the time of the Greek bailout was to point to the generosity of Greek state provision by comparison with Germany’s own, and the Germans have been through a series of painful pension and labour market reforms in the last ten years. Even in France the pension age was recently raised, despite high profile public protests

If (and it’s a big if) these proposals are adopted, what then? In my view it’s not all good news for the periphery. The demand for austerity to reduce public debts would continue. The abolition of wage indexation would put pressure on real incomes, especially if commodity prices continued their current climb. The modification of pension entitlements would encourage consumers to save more, putting pressure on consumption. In the background, we have the ECB talking about the need to be vigilant about inflation; were this to translate into increases in interest rates, this would bear down disproportionately on the periphery, since mortgages in northern Europe tend to be at fixed rates, whereas in the periphery they are mainly at floating rates tied to ECB rates.

It would certainly be good news for peripheral bonds, which may be why spreads have tightened so much – and may still have further to go. Lastly, it may well instil some confidence in the euro as a currency, although if the euro started to strengthen against the US dollar it would diminish the competitiveness of Northern European exporters in the short to medium term.

None of this will be welcome news to dyed-in-the-wool Eurosceptics, who have viewed the events of the last two years as vindicating their long-held conviction that the euro was a house built on sand. The problem for Eurosceptics is that the euro is not wholly an economic project, nor wholly a political project, and it’s certainly not a popular project. It is though, a historical project, driven by the will for greater union in the region, and as long as enough is being done on the economic, political and popular front to keep it alive, the historical imperative will continue to drive it forward